When comparing ISOs vs. NSOs, the biggest differences come down to how each is taxed and who can receive them. Employees often receive incentive stock options (ISOs), which can receive preferential tax treatment when specific holding periods are satisfied. Non-statutory stock options (NSOs), on the other hand, trigger ordinary income tax at exercise. Understanding these distinctions can affect the total cost and timing of taxes owed.
What Are Stock Options and How Are They Taxed?
Stock options are contracts that give employees the right to buy company stock at a set price, known as the strike price or exercise price, after a specified vesting period. Companies use stock options as part of compensation packages to align employee interests with long-term company performance.
There are two different types of stock options: ISOs and NSOs, or non-qualified stock options.
When you exercise an option, you need to be aware of the bargain element—the gap between a stock option’s exercise price and its market value when the option is exercised. For example, if your option allows you to buy shares at $30 and the current market value is $60, the bargain element is $30 per share. This amount represents a form of compensation and plays a key role in how stock options are taxed.
How the IRS taxes your options depends on different factors. These include how long you’ve had the shares, when you exercise them, and the price at which you bought them. The value of the stock, and your profit from any sale, also plays a role.
The IRS uses the bargain element to figure out how much of the stock option’s value will count as income. This calculation has a range of tax implications that are time-sensitive.
NSOs vs. ISOs: How They Are Taxed at Exercise
The tax treatment at the time of exercise is one of the key differences between ISOs and NSOs. When you exercise NSOs, the difference between the exercise price and the stock’s fair market value—known as the bargain element—is treated as ordinary income. This amount is reported on your W-2 and is subject to federal income tax, plus Social Security and Medicare taxes. However, income taxes on NSOs are typically withheld at the time of exercise.
In contrast, ISOs are not taxed at exercise under the regular income tax system. Instead, the bargain element is not included in your W-2 or taxed as ordinary income at that point. However, it is included as income for alternative minimum tax (AMT) purposes, which can increase your tax liability depending on your overall income and deductions.
In short, NSO exercises result in immediate taxable income, while ISO exercises may defer taxes—unless AMT applies. This difference makes ISOs more tax-efficient in certain cases, but they come with stricter rules and potential AMT exposure that NSO holders don’t face.
What Is AMT and How Does it Apply to ISOs?
The AMT works alongside the regular tax system and kicks in when certain deductions or credits significantly reduce a taxpayer’s bill. AMT ensures higher earners still pay a baseline level of tax. To determine whether the AMT applies, you have to compute your tax liability under both the standard tax system and the AMT framework, then pay the higher of the two amounts.
The AMT uses its own exemptions, income thresholds and rates to determine what’s owed. If exercising the ISOs pushes your income above the AMT exemption threshold, you may owe additional tax for that year, even if you don’t sell the shares.
AMT Exemptions in 2025
| Filing Status | Exemption Amount | Phase-Out Begins | Phase-Out Ends |
|---|---|---|---|
| Single or Head of Household | $88,100 | $626,350 | $978,750 |
| Married Filing Jointly | $137,000 | $1,252,700 | $1,800,700 |
| Married Filing Separately | $68,500 | $626,350 | $900,350 |
| Estates and Trusts | $30,700 | $102,500 | $225,300 |
The exemption is reduced by 25 cents for every $1 of alternative minimum taxable income (AMTI) over the threshold until a certain level. The resulting AMTI (after subtracting the AMT exemption amount) is then taxed at the following rates:
- The first $239,100 of AMTI is taxed at 26%
- Any amount above $239,100 is taxed at 28%
ISOs vs. NSOs: How They Are Taxed When Sold
The tax treatment of stock options changes once the shares are sold, and the differences between ISOs and NSOs become more apparent.
For ISOs, the timing of the sale determines whether you receive favorable tax treatment. If you hold the shares for at least one year after exercising and two years after the grant date, any profit is taxed as a long-term capital gain. Selling earlier triggers a disqualifying disposition, where the bargain element is taxed as ordinary income, and any additional gain is taxed as a capital gain (short- or long-term depending on the holding period after exercise).
For NSOs, the bargain element is already taxed as ordinary income at exercise. When you later sell the shares, any increase or decrease in value is treated as a capital gain or loss. Gains from shares held for over a year after exercise qualify for long-term capital gains tax treatment. Selling the shares sooner results in short-term capital gains, which are taxed at the same rates as ordinary income.
ISOs offer more favorable tax treatment at sale if holding requirements are met, but NSOs involve simpler and more predictable tax consequences.
Long-Term Capital Gains Tax Rates in 2025
| Rate | Single | Married Filing Jointly | Married Filing Separately | Head of Household |
|---|---|---|---|---|
| 0% | 0 – $48,350 | 0 – $96,700 | $0 – $48,350 | $0 – $64,750 |
| 15% | $48,350 – $533,400 | $96,700 – $600,050 | $48,350 – $300,000 | $64,750 – $566,700 |
| 20% | $533,400+ | $600,050+ | $300,000+ | $566,700+ |
Bottom Line
ISOs and NSOs follow distinct tax rules that can lead to very different outcomes. ISOs offer potential tax advantages but come with holding requirements and possible AMT exposure, while NSOs are taxed as ordinary income at exercise and have fewer restrictions. Understanding the timing and tax treatment of each type can help employees make informed decisions about when to exercise and sell, especially when stock compensation plays a major role in total earnings.
Portfolio Management Tips
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